## Annuity

## Sell Your Annuity

Do you have annuity you dont want? Discover When is it Time to Sell Your Annuity? What can I do? Where can I get the money I need? I have an annuity, but I dont know that I can sell it. Is there a good time to sell my annuity? I already have a home improvement loan, but it was used before the roof needed replacing.

## Variable Annuities United States

The U.S. variable-annuity (VA) contract is a separate account insurance, very similar to the Canadian segregated fund contract. The VA market is very large, with over 100 billion of annual sales each year in recent times. Premiums net of any deductions are invested in subaccounts similar to the mutual funds offered under the segregated fund contracts. GMDBs are a standard contract feature GMMBs were not standard a few years ago, but are beginning to become so. They are known as VAGLBs or variable-annuity guaranteed living benefits. Death benefit guarantees may be increased periodically.

## The Present Value Of An Annuitycertain

The following types of annuity-certain are particularly important in investment and it is therefore useful to know the general formulae for their present values. (4) An increasing annuity in which the first payment is one after one interval, the second payment is two after two intervals, and so on, with a final payment of n after n intervals

## Equity Indexed Annuities United States

The U.S. equity-indexed annuity (EIA) offers participation at some specified rate in an underlying index. A participation rate of, say, 80 percent of the specified price index means that if the index rises by 10 percent the interest credited to the policyholder will be 8 percent. The contract will offer a guaranteed minimum payment of the original premium accumulated at a fixed rate a rate of 3 percent per year is common.

## Solving For Rates Number Of Periods Or Size Of Annuity Payments

In the previous examples, certain pieces of information have been made available. For instance, all problems have given the rate of interest, r, the number of time periods, N, the annuity amount, A, and either the present value, PV, or future value, FV. In real-world applications, however, although the present and future values may be given, you may have to solve for either the interest rate, the number of periods, or the annuity amount. In the subsections that follow, we show these types of problems. 7.3 solving for In this section, we discuss how to solve for annuity payments. Mortgages, auto loans, and the slze of retirement savings plans are classic examples of applications of annuity formulas. Annuity Payments EXAMPLE l-20.The Annuity Payments Needed to Reach a Future Value with Monthly Compounding. , to solve for the annuity amount, A, as the present value divided by the present value annuity factor Present value annuity factor A PV Present value annuity factor 100,000...

## Tax Treatment For Annuities

Annuities are very much like IRAs, in that the money grows tax-deferred, and the annuity owners cannot take any distributions from the contracts until they are at least 591 2 years old. All money invested in an annuity is done so after tax, and there is no tax deduction for investing in an annuity unless it is done inside an IRA annuity. Then, any tax deduction is subject to the same limits that other IRA contributions are subject to (i.e., 3000 per year). In most cases, those who take money out of their annuity contracts before they are 591 2 will face a 10-percent IRS penalty for early withdrawal, plus they will be responsible for taxes on the money that was withdrawn. Taxes are paid at ordinary income rates, regardless of how long the annuity has been held. For nonqualified annuities (those not within an IRA plan), the annuity owner's investment in the contract is the total premium amount paid, less any nontaxed distributions. Because the contract owner has paid in after-tax...

## Equity Indexed Annuities

Equity indexed annuities, or EIAs, are a relatively new form of fixed-dollar annuities. They blend minimum insurance company guarantees with linking the annuity's interest earnings to a stock market index, such as the S&P 500. While there are many different designs of EIAs being sold, we use just one as an example. Let's say you invest 50,000 as a single-premium deferred EIA. The particular policy you purchase will guarantee a minimum value of 85 percent, or 42,500, of your principal amount. The value of the EIA will not fall below the minimum guaranteed value, which is 42,500 in this example. Plus, if it is higher, the EIA will pay a percentage of the increase in an equity index over a specified time period. The percentage paid will vary among the different insurers, and even the different EIAs offered by the same insurer. For this example, we'll use 80 percent. We'll also use the S&P 500 as our stock index and 10 years as our time frame. The percentage of the index increase is...

## General Annuity Features Beneficiaries

Annuity contracts allow the owners to name beneficiaries. One of the reasons that annuities are attractive to investors is because they have a built-in death benefit. Just like the EIA has a minimum guaranteed value, an annuity contract states that if the value of the contract is less than the original premium, minus any withdrawals or loans, the owner's beneficiary upon the owner's death shall receive the original premium amount. However, if the annuity is valued at more than the original premium amount, the beneficiary will receive that larger amount. For example, James Client invests 100,000 in a deferred variable annuity. Four years later, Mr. Client dies. Prior to his death, he hadn't taken any money out of the annuity. His beneficiary for the annuity, his daughter, claims the annuity, which is now valued at 89,000. Because Mr. Client hadn't taken any money out of the annuity, his daughter receives 100,000 the original premium amount. If the beneficiary of the annuity owner is...

## Annuities Not Held by Natural People

Annuities may be held by entities, rather than natural people. However, for tax purposes, any deferred annuities would not be treated as annuities and, thus, wouldn't be tax-deferred. Any gain made on the annuity would be taxed to the owner as ordinary income. This includes any annuities held by corporations, charitable remainder trusts, and certain other entities. This doesn't include annuities held by an estate because the owner has died, any annuities held by trusts or other entities acting on behalf of a natural person, annuities within qualified retirement plans, tax-sheltered annuities, or IRAs and immediate annuities.

## Table 61 General Surrender Charge Schedule for Annuities1

After the tenth year, you would be able to draw out as much of the contract's value as you wished. This is actually a contingent deferred sales charge, since it isn't levied unless you pull out more than the allowable maximum. More commonly, though, it is called a back-end load. Back-end loads are designed to discourage the annuity owner from transferring his or her money to a different company, or taking it out altogether. There are some insurers who don't charge any type of sales charge. These annuities are akin to no-load mutual funds.

## How Annuities Will Help

Annuities are great for investing your after-tax dollars on a tax-deferred basis. Think about it. If you could put away money and then not be taxed on the growth, might your overall nest egg grow faster Annuities help people shelter their money from the government for a time, even if it is a limited time. Plus, for annuities outside an IRA, there is no limit to the amount of money that can be sheltered. Annuities inside an IRA are subject to the regular contribution limits. Annuities also provide a level of comfort for people who are concerned that they may outlive their money. They also provide a good way to help your money grow tax-deferred. Another advantage to annuities is the guaranteed death benefit. The disadvantages associated with annuities are the internal expense charges, surrender charges, and the possibility of limited subaccount fund availability within variable annuities. While annuities sound like a great investment, they're not for everyone. Be sure the annuity you...

## Annuities and Commissioned Sales

Out of 696 annuity contracts in the Morningstar Principia database updated through February 2004 three of which are closed to new business only sixteen charge a front load. Clearly, a front load is a consumer-unfriendly feature that the buyer can choose to avoid. If the front load provided value with offsetting expense reductions or unique features, it might be justified, but such value in the cases reviewed is not apparent. Similarly, annual contract charges for account values in excess of 50,000 may not be competitive, and total base annuity expense ratios above 2.5 percent may not be competitive. But annuity purchasers Within an annuity total expense ratio of 2.5 percent, such as mentioned above, we've included the contract's mortality and expense (M&E) charge (which includes the basic features of an annuity and the insurance features, such as a guaranteed minimum death benefit of the account value, or the amount that's been invested in the contract less withdrawals), a guaranteed...

## Optimal Allocation to Annuities

Traditionally, asset allocation is determined by constructing efficient portfolios for various risk levels based on modern portfolio theory.12 Then, based on the investor's risk tolerance, one of the efficient portfolios is chosen. Modern portfolio theory is widely accepted in academia and financial industries as the primary tool for developing asset allocations. However, its effectiveness is questionable when dealing with asset allocations for individual investors in retirement because the theory does not take longevity risk into account. Asset-allocation decisions that take advantage of diversification benefits across different asset classes are an effective way to manage and reduce market risk. As discussed above, longevity risk can be hedged away with insurance products such as lifetime payout annuities. Therefore, fixed- and variable-payout annuities must be incorporated into traditional asset-allocation models to help investors find the appropriate allocation of their savings in...

## Immediate Annuity Implementation Decisions

Jim Otar, author of High Expectations and False Dreams, discusses an annuity ladder concept in which the client and financial adviser determine what percentage of a client's retirement capital will be needed to sustain the desired standard of living. (For Otar's latest thinking on this subject, go to his website at www.cotar.org.) If that percentage withdrawal is not likely to diminish the amount of capital, income needs are comfortably satisfied and no annuitization is needed. Otar calls this a retiree with abundant savings. If, however, there is some likelihood that principal will be used to provide for income needs, leaving less capital available to provide for future income needs, then some annuitization is needed. For some this will be a bright line test of whether annuities must be considered. Although Otar uses a very specific formula to guide the decision about how much to annuitize, the formula is based on assumptions on which individual advisers and clients may not...

## Fixed Annuity vs a Bond Portfolio

A theoretical bond portfolio has a beginning value of 100,000, the same as the capital to be placed into an immediate fixed annuity contract. The figure 10.6 Immediate Life Annuity or Fixed Payments From a _Fixed-Interest Investment Portfolio_ Single-life annuity Current immediate annuity quotes from www.immediateannuities.com or similar site theoretical bond portfolio earns a steady 5 percent, from which 7,500 per year is extracted to match what the annuity contract will pay out to our sixty-five-year-old male retiree. It appears, according to the mortality tables, that the bond fund will be exhausted before the retiree's death. Choosing between these two investments depends on the investor's view of the risks involved. There are two ways to relieve clients of their concern about running out of money during their lifetimes annuitization or taking earnings only. Taking earnings only leaves the principal to the beneficiaries, but in this case, a 50 percent increase in income is...

## Annuities

Annuities are investment products with some tax and insurance twists. They behave like savings accounts, except that they give you slightly higher yields, and they're backed by insurance companies. As in other types of retirement accounts, the money that you put into an annuity compounds without taxation until withdrawal. However, unlike most other types of retirement accounts 401(k)s, SEP-IRAs, and Keoghs an annuity gives you no tax deductions. Annuities also charge relatively high expenses. That's why it makes sense to consider contributing to an annuity only after you fully fund the tax-deductible retirement accounts that are available to you. The best annuities available today are distributed by no-load (commission-free) mutual fund companies. For more information about the best annuities and situations for which annuities may be appropriate, be sure to read Chapter 10.

## Perpetual Annuities

As a step toward the development of the formula we consider an interesting and conceptually useful fixed-income instrument termed a perpetual annuity, or perpetuity, which pays a fixed sum periodically forever. For example, it might pay 1,000 every January 1 forever Such annuities are quite rare (although such instruments actually do exist in Great Britain, where they are called consols). The present value of a perpetual annuity can be easily derived Suppose an amount A is paid at the end of each period, starting at the end of the first period, and suppose the per-period interest rate is . Then the present value is V Perpetual annuity formula The present value P of a perpetual annuity that pays an 7 amount A every period, beginning one period from the present, is Example 3.1 (Perpetual annuity) Consider a perpetual annuity of 1,000 each year. At 10 interest its present value is

## Immediate Annuities

Immediate annuities require the annuitant to pay a lump sum of money, rather than paying a number of premiums over time. The payouts to the annuitant begin as soon as the lump-sum payment is received, or the annuity start date. This date is the first day of the first period (i.e., month) for which an amount is received as an annuity, under the current tax law. A likely use of an immediate annuity is by someone who is about to retire and would like to receive monthly income right away. An immediate annuity can be paid out in either fixed or variable amounts.

## Deferred Annuities

In contrast to immediate annuities, deferred annuities can have one lump-sum payment by the annuitant, or the annuitant can pay a set of premiums over time. The payouts for deferred annuities typically don't start for at least one year after the purchase payments have ended. Usually, payouts don't occur until many years later. However, just with immediate annuities, the payouts may be either fixed or variable. Deferred annuities make up the larger segment of annuity contracts that are purchased due to the IRS rules governing annuity

## Annuity Phases

Individual annuities have two different phases the accumulation phase and the distribution phase. The annuity owner pays premiums and the contract value grows due to the premiums during the accumulation phase. There is no tax The distribution phase begins once the annuity owner begins to receive the annuity's payouts. There are a few limiting factors to when the distribution period may begin. First, the owner must be at least 591 2 years old, otherwise he or she will be subject to the IRS's 10 percent early withdrawal penalty. Of course, there are a few exceptions. Second, annuities carry surrender charges. Therefore, you will want to defer the distribution phase until the surrender charges have declined or have been eliminated. Finally, annuity contracts generally stipulate the maximum age at which distributions must start. However, this is usually a quite advanced age, such as 87. There are no tax laws that specify a required beginning date for nonqualified annuities.

## Fixed Annuities

Fixed annuities, or fixed-dollar annuities, grow at a guaranteed rate. At the beginning of the annuity contract, the insurance company and the annuity owner enter into an agreement through which the owner will pay a stated amount in premiums and the insurance company will pay a set rate of interest. While the insurance company will lock in a specified interest rate at the beginning, future interest rates will vary according to current market conditions. However, the insurance company will specify for what length of time the interest rate is good. It may be for as short as two months, or as long as five years. Many times, the subsequent interest rates are lower than the initial rate. Generally, though, annuity contracts will have a minimum guaranteed interest rate, below which the insurance company cannot set its rate. The contract may also have a bailout provision designed to protect annuity owners. This provision states that if the insurance company sets its rates below a certain...

## Variable Annuities

Variable annuities offer a number of different investment choices inside of the annuity, known as subaccounts. When establishing the variable annuity, owners can choose where they want their premiums to be invested each time. They can then change around the subaccount allocation whenever they want. The owner may also move money between the different subaccounts, both with no cost to the owner and with no tax consequences. The different types of investment subaccounts, or separate accounts, are not part of the insurance company's general assets. These subaccounts and their investment results stand on their own. The performance of the annuity contract as a whole depends upon the performance of the separate subaccounts, most of which are tied directly to the stock market. Therefore, the investment risk lies with the annuity owner, not the insurance company. Since the subaccounts aren't part of the company's general assets, should the company become insolvent, the variable annuity owners...

## Annuity Wrappers

Annuity contracts (deferred, immediate, fixed, and variable) are financial tools intended to address the risk-management issues surrounding retirement capital. Annuities must, net after expense, prove to be credible and efficient financial tools capable of accomplishing client goals as well as, or better than, other alternatives. The Nonqualified Annuity Annuities compete for the consumer's investment dollars in an environment of changing and expanding investment opportunities and complex and changing personal needs. A nonqualified annuity is a financial tool that can help accomplish retirement financial goals using after-tax capital. The nonqualified annuity is constructed and enabled by the tax code to encourage long-term accumulation and long-term distribution of retirement capital while permitting the deferral of taxation until distribution. Under current federal law, distributions are taxed as ordinary income. Many advisers regard it as a disadvantage for clients to use after-tax...

## Annuity Method

The annuity method (AM) uses the same discounted cash flow model as the NPV method. The only change is a different target measure, the annuity An annuity is a series of cash flows of equal amounts in each period of the total planning period. The annuity can be regarded as an amount that an investor can withdraw in every period when undertaking the investment project. The annuity of an investment project is equivalent to the NPV of that project, i.e. it is possible to equate both measures mathematically. A limitation of this approach is that the annuity method is not (completely) suitable for the assessment of relative profitability. This will be further outlined below. Setting this issue aside for now, however, the following profitability criteria can be applied Absolute profitability is achieved if an investment project's annuity is greater than zero. Relative profitability An investment project is preferred if it has a higher annuity than the alternative investment project(s). When...

## Annuity Prices

We will estimate approximate prices for an immediate annuity of 1 per year for a male annuitant aged 65, payable continuously through life, using current Canadian annuitants' mortality1 from Appendix A, and using historic U.K. interest rates. Because guaranteed annuity options have proved most troublesome in the United Kingdom, in this chapter we will use parameters for simulation appropriate for U.K. data. In Figure 12.1 the estimated values of a whole-life annuity are plotted based on historic interest rates. For simplicity, the term structure has been assumed to follow a straight line between the three-month rate and the 2.5 percent consols rate, which is assumed to apply for all terms of greater than five years. The 2.5 percent consols used for the long-term rate are effectively irredeemable U.K. government bonds. The horizontal line on the plot gives the threshold for a nonzero liability for a guaranteed annuity option with a guaranteed annuity conversion rate of 1 for 9 lump...

## Demographics and Individual Investment Decisions

These profound changes in population demographics have been accompanied by major shifts in the ways in which people save and invest for retirement in many countries. There is an increasing reliance on schemes involving defined contributions (DC). In a standard case an employee decides how much to deduct from wages or salary each month. This amount, plus a possible contribution by the employer, is then invested in investment vehicles (such as mutual funds) selected from a list provided by the employer. The employee is responsible for allocating funds among the investment vehicles. When the employee reaches retirement, he or she has access to the ending value of the money that has been invested. At that point the money can be re-invested, used to purchase an annuity, or both. Unless funds are fully annuitized, the individual will then have decisions to make about the amounts to be spent each year until he or she (and often a partner) dies. Defined contribution plans provide the...

## The Present Value Of A Series Of Cash Flows

6.1 The Present We begin with an ordinary annuity. Recall that an ordinary annuity has equal annuity pay-value of a series ments, with the first payment starting one period into the future. In total, the annuity makes of equal Cash N payments, with the first payment at t 1 and the last at t N. We can express the flows present value of an ordinary annuity as the sum of the present values of each individual annuity payment, as follows A the annuity amount r the interest rate per period corresponding to the frequency of annuity payments (for example, annual, quarterly, or monthly) N the number of annuity payments Because the annuity payment (A) is a constant in this equation, it can be factored out as a common term. Thus the sum of the interest factors has a shortcut expression In much the same way that we computed the future value of an ordinary annuity, we find the present value by multiplying the annuity amount by a present value annuity factor (the term in brackets in Equation 1-11)....

## Your Advisorgood Or

Although no one expects you to become an expert on every aspect of your portfolio, that's what your advisor is for, you should have some understanding of its components. If your advisor recommends investing in an annuity, make sure you are familiar with what an annuity is. Don't be afraid to ask questions it will make you feel better. Be sure you are comfortable with the answers your advisor gives you, as well as with each individual product.

## Unit Linked Insurance United Kingdom

Some unit-linked contracts associated with pensions policies carry a guaranteed annuity option, under which the fund at maturity may be converted to a life annuity at a guaranteed rate. This is a more complex option, of the GMIB variety. This option is discussed in Chapter 12.

## Establishing A Financial Plan

The income paid on investments in certain tax-deferred products, like deferred annuities and universal life insurance, is not immediately taxable. Unlike tax-exempt income, tax deferment simply postpones the payment of taxes until receipt of this income at a later date. This helps reduce your tax bill in that by the time you receive the income from these investments, you may possibly be in a lower tax bracket, thus reducing the tax due. I explain all of this more in a later chapter.

## Amortization Alone Often Beats Other Investments

You might not think 8 percent sounds like much of a return. But it's certainly better than bonds, annuities, certificates of deposit, and even stocks (during many decades of our economic history). Indeed, the famous stock market bull,Wharton professor Jeremy Siegel, forecasts average stock returns over the next 10 to 20 years of just 6 to 8 percent a year. Why Because stocks today remain highly overvalued relative to historical norms.

## Taxadvantaged Planspros And Cons

Tax-advantaged, or qualified, plans include qualified retirement plans (i.e., 401(k)s), traditional IRAs, variable annuities, and variable life insurance policies and the like. (See Chapter 6 on annunities.) While each type of tax-advantaged investment has its own pluses and minuses, the following advantages and disadvantages apply to each.

## Taxdeferred Investments Within Qualified Plans

There are both advantages and disadvantages of holding tax-deferred investments inside qualified plans. For example, I'm not adverse to advising clients to hold an annuities within their IRAs. Annuities have the tax-deferred advantage built into them. (All capital gains, dividends, and taxable interest accrue tax-deferred until the owner begins to make distributions.) However, I believe that owning a fixed annuity inside an IRA helps provide stability to the overall portfolio. This extends to variable annuities. There are situations in which I recommend to my clients to purchase variable annuities within their IRAs. Annuities have a death benefit guarantee as one of their benefits. This means that if you purchase an annuity for 100,000, and at the time of your death the annuity contract is worth 86,000, your heir will receive the 100,000 that you invested. This gives a lot of older, married couples peace of mind because they aren't very aggressive, and are worried about what their...

## Most Calculatorsfor This Problem

Using the IRR function in a spreadsheet or an IRR-enabled financial calculator, we enter the individual cash flows and apply the IRR function. We illustrate how we can solve for IRR in this particular problem using a financial calculator without a dedicated IRR function. The cash flows from t 1 through t 6 can be treated as a six-year, 4 million annuity with 7 million - 4 million 3 million, entered as a future amount at t 6.

## Description of the Data

For segregated fund and variable-annuity contracts, the relevant data for a diversified equity fund or subaccount are the total returns on a suitable stock index. For the U.S. variable annuity contracts, the S&P 500 total return (that is with dividends reinvested) is often an appropriate basis. For equity-indexed annuities, the usual index is the S&P 500 price index (a price index is one without dividend reinvestment). A common index for Canadian segregated funds is the TSE 300 total return index1 (the broad-based index of the Toronto Stock Exchange) and the S&P 500 index, in Canadian dollars, is also used. We will analyze the total return data for the TSE 300 and S&P 500 indices. The methodology is easily adapted to the price-only indices, with similar conclusions.

## Attributes of Superior Performers

Differentiation refers to any number of attributes that might separate one company from another, such as product quality, customer service, intellectual property, regulatory benefits, and annuity revenue streams. Cost structures include innovations, efficiencies, contracts, distribution positions, and shrewd purchasing decisions that produce long-term cost savings unavailable to competitors.

## The Mechanics of Present Value

In general, there are five types of cash flows that we will encounter in valuing any asset. You can have a single cash flow in the future, a set of equal cashflows each period for a number of periods (annuity), a set of equal cashflows each period forever (perpetuity), a set of cashflows growing at a constant rate and each period for a number of periods (growing annuity) and a cash flow that grows at a constant rate forever (growing perpetuity). What about the present value of an annuity You have two choices. One is to discount each of the annual cashflows back to the present and add them all up. For instance, if you had an annuity of 5000 every year for the next 5 years and a discount rate of 10 , you could compute the present value of the annuity in figure 4.1

## The Right Assets for the Family Portfolio

Suppose Mary, age sixty-five, just retired with 1 million in financial assets. All assets are in taxable accounts, and the market values and book values are equal. Following the advice of Gary, her financial planner, she invests 600,000 in stocks funds and 400,000 in bond funds. She will withdraw 2,400 automatically each month from her bond funds. One month later, Mary asks Gary about the advantages and disadvantages of an immediate fixed annuity with a lifetime payout option and no guaranteed certain period. He explains that the major advantage is that this payout annuity would provide a monthly payment for the rest of her life. The major disadvantage is that, after her death, the annuity would be worthless, so there would be no remaining value to bequeath. Since both of her parents lived into their nineties and Mary has no children, the trade-off appeals to her. At Gary's recommendation, she purchases an immediate fixed annuity with the proceeds from the bond...

## Rising Wealth Keeps Consumers Spending

A Prudential annuity gives you choices Maybe you'd travel. Perhaps start a new business. Definitely see more of the people who mean the most to you. And it all starts with knowing that your annuity from Prudential and American Skandia can help protect your retirement income and provide income guaranteed for the life of your retirement. It feels good just thinking about it, doesn't it More than 30,000 independent financial planners, stockbrokers, bank investment representatives and Prudential financial professionals offer Prudential American Skandia annuities. Ask your financial professional if an annuity is right for you. 10 2005. The Prudential Insurance Company of America, Newark, NJ, and American Skandia Life Assurance Corporation, Shelton, CT. Annuities contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. Your licensed financial professional can provide costs and complete details. Guarantees are dependent on the claims-paying ability of the...

## Do uorry about these but not too much

V Volatility of your investment balance. When you invest in mutual funds that hold stocks and or bonds, the value of your funds fluctuates with the general fluctuations in those securities markets. These fluctuations don't happen if you invest in a bank certificate of deposit (CD) or a fixed insurance annuity that pays a set rate of interest yearly. With CDs or annuities, you get a statement every so often that shows steady but slow growth in your account value. You never get any great news, but you never get any bad news either (unless your insurer or bank fails, which could happen).

## Analysis of Fixed Income Securities 731 The NPV Approach

Figure 7-1 shows the time profile of the cash flows Ct for three bonds with initial market value of 100, 10 year maturity and 6 annual interest. The figure describes a straight coupon-paying bond, an annuity, and a zero-coupon bond. As long as the cash flows are predetermined, the valuation is straightforward.

## Mortgage Backed Securities 751 Description

Mortgage-backed securities represent claims on repackaged mortgage loans. Their basic cash-flow patterns start from an annuity, where the homeowner makes a monthly fixed payment that covers principal and interest. The next step is to project cash flows based on the prepayment speed pattern. Figure 7-5 displays cash-flow patterns for a 30-year MBS with a face amount of 100 million, 7.5 interest rate, and three months into its life. The horizontal, 0 PSA line, describes the annuity pattern without any prepayment. The 100 PSA line describes

## Equity Participation

Guaranteed Minimum Income Benefit (GMIB) The guaranteed minimum income benefit (GMIB) ensures that the lump sum accumulated under a separate account contract may be converted to an annuity at a guaranteed rate. When the GMIB is connected with an equity-linked separate account, it has derivative features of both equities and bonds. In the United Kingdom, the guaranteed-annuity option is a form of GMIB. A GMIB is also commonly associated with variable-annuity contracts in the United States.

## Insurance Companies As Hedge Fund Investors

Combined with hedge funds, whose returns are generally taxed immediately at the maximum individual income tax rate. Whole-life insurance policies allow the cash value to grow free from income tax and can be structured to avoid estate tax. Deferred annuities can also allow investment balances to grow without being taxed until the return is distributed years later. These insurance products are expanding the range of allowable investments to include hedge funds, extending their favorable tax treatment to hedge fund returns.

## The Ad Hoc Approach

For any actuary tempted by this approach, the Equitable Life (U.K.) story provides a clear demonstration of the risks of ignoring statistical methodology. Along with many U.K. insurers in the early 1980s, Equitable Life (U.K.) issued a large number of contracts carrying guaranteed-annuity options, under which the guarantee would move into the money only if interest rates fell below 6.5 percent. At the time the contracts were issued, interest rates were higher than 10 percent, and a cautious long-term view was that they might fall to 8 percent. Many actuaries, relying on their personal judgment, believed that these contracts would never move into the money, and therefore made little or no provision for the potential liability. This conclusion was made despite the fact that interest rates had been below 6.5 percent for decades up to the later 1960s. Of course, in the mid-1990s rates fell, the guarantees moved into the money, and the guarantee liabilities

## Client Invests 5million Portfolio And Invests 5 Percent Of It In A Money Market Fund Projected To Earn3 Percent

TABLE 1-6 How an Initial Present Value Funds an Annuity To interpret Table 1-6, start with an initial present value of 4,329.48 at t 0. From t 0 to t 1, the initial investment earns 5 percent interest, generating a future value of 4,329.48(1.05) 4,545.95. We then withdraw 1,000 from our account, leaving 4,545.95 - 1,000 3,545.95 (the figure reported in the last column for time period 1). In the next period, we earn one year's worth of interest and then make a 1,000 withdrawal. After the fourth withdrawal, we have 952.38, which earns 5 percent. This amount then grows to 1,000 during the year, just enough for us to make the last withdrawal. Thus the initial present value, when invested at 5 percent for five years, generates the 1,000 five-year ordinary annuity. The present value of the initial investment is exactly equivalent to the annuity. Now we can look at how future value relates to annuities. In Table 1-5, we reported that the future value of the annuity was 5,525.64. We arrived...

## Help Im Running Out Of Money

Annuities act in opposition to life insurance. While life insurance protects you financially against an early or unexpected death, annuities protect you from the financial risk of living too long and outliving your money. There are different types of annuities including immediate, deferred, fixed, and variable. Annuities are a special form of investment that is a contract between, the investor, and the issuing insurance company, that states that the insurance company will pay you a series of payments for either a specific period of time or for the rest of your life. In the past, a life annuity contract consisted of a person paying an insurance company a specified amount of money in exchange for the guarantee that the insurance company would make periodic payments to this person for the rest of his or her life, thus ensuring that this person wouldn't outlive his or her money. However, individual annuity contracts these days allow the payout of accrued money in different ways....

## Valuation of Alternative Investments

Applying the valuation theory, which states that the value of any asset is the present value of its cash flows, the value of the bond is the present value of the interest payments, which we can think of as an annuity of 500 every six months for 15 years, and the present value of the principal payment, which in this case is the present value of 10,000 in 15 years. The only unknown for this asset (assuming the borrower does not default) is the required rate of return that should be used to discount the expected stream of returns (cash flows). If the prevailing nominal risk-free rate is 9 percent and the investor requires a 1 percent risk premium on this bond because there is some probability of default, the required rate of return would be 10 percent. The present value of the interest payments is an annuity for 30 periods (15 years every six months) at one-half the required return (5 percent) 6 6The annuity factors and present value factors are contained in Appendix C at the end of the...

## Investing in Investment Funds

* It is a violation of Federal law for an open-end mutual fund, a closed-end fund, or an exchange-traded fund to sell shares to the public unless it has registered (or made mandatory financial filings) with the SEC. t The fund industry has gone from very large to immense. At year-end 2002, there were 8,279 mutual funds holding 6.56 trillion 514 closed-end funds with 149.6 billion in assets and 116 exchange-trade funds or ETFs with 109.7 billion. These figures exclude such fund-like investments as variable annuities and unit investment trusts.

## Selecting the Benchmarks

To illustrate differences in conventional wisdom, U.K. pension funds historically invested 80 or more of their portfolios in common stocks, U.S. pension funds 60 to 70 , Canadian pension funds were at one time more like 40 , and Swiss pension funds closer to zero. (Many Swiss pension plans preferred simply to buy annuities.) Such asset allocations are influenced partly by local laws, but in most cases, Company A follows an approach because it's conventional wisdom it's the approach followed by peers in its country. Aren't all pension funds worldwide trying to do the same thing An optimal approach for investing a pension fund in one country is probably pretty close to an optimal approach in another country. Except for conventional wisdom herd mentality.

## Mutual Funds and Commissioned Sales

ANNUITY Annuity taxed at 25 Net after-tax annuity (if liquidated) Annuity income after-tax for life (no ifs) Annuities Most often no front load back loads average 6 reducing for 7 years Long-term investors who value the annuity contract features and are accumulating retirement capital (see www.bloomberg.com thinktank).

## Annuitization A Portfolio Stress Reliever

One approach to this problem could be to relieve the stress on the portfolio of providing income during these difficult periods. For example, in mid-2003, it would have taken approximately 58,893 in capital to relieve a portfolio of the requirement to pay out 1,000 per month for a five-year period, or 105,374 for ten years.10 The payment amounts are based on an average of sixteen companies in the database ofWebAnnuities.com. Although the interest earnings are not impressive in these examples, interest rates in general were not impressive as of that date. Fixed-amount or fixed-period annuity payments such as this are purchased because the relative interest rate is better than what can be attained elsewhere, and they provide the convenience of having one monthly required payment of 1,000 to cover living expenses rather than having to do piecemeal liquidations from a volatile investment portfolio. This type of annuitization also allows the balance of the portfolio to be managed for...

## The Systematic Withdrawal Plan

The Ibbotson Associates PowerPoint presentation Variable Annuity Investing, published in the spring of 2003, offers an excellent example of the frailty of trying to use a diversified investment portfolio as an income generator. The portfolio used in the example had a value on December 31, 1972, of 500,000, invested 50 percent in the Standard & Poor's 500 stock index and 50 percent in 5-year U.S. government bonds. The consumer price index was used as the measure of inflation, and the income to The study also implied that for asset-allocation purposes, the annuity can be considered a type of bond. The mission of the bond portfolio is to generate income, which certainly is the task of immediate annuities. This may mean that some advisers will, depending on interest rate assumptions, consider the flow of 40,000 to 50,000 of ever-replaceable annual income (be it from Social Security, pensions, or annuity income) to be equivalent to a 1 million bond portfolio and will treat it as such in a...

## Financial planning and the time horizon

This focus on controlling volatility often involves restricting interest rate exposure in investment portfolios. Bond market developments in recent years show how this approach can put at risk the spending power of long-term investors. The flip side of the succession of profitable opportunities to refinance fixed-rate mortgages around the turn of the century was the much less publicised but more important phenomenon for retirement saving the sequence of increases in the cost of purchasing continuing flows of income whether in the form of government bonds or life annuities from insurance companies. Meanwhile, the cost of buying inflation-proof can be grown for the family. This ignores the scope for buying food with the proceeds of at least some of the cash crop, so it is quite likely that this safety-first approach will lead to a lower standard of living, on average, than a greater focus on the volatile cash crop might have provided. The equivalent investment approach is to hedge away...

## The Grass Always Looks Greener On The Other Side

Once the deal seems to be workable between the parties, the details should be discussed. Of course, the method of payment of the mortgage will not work in all situations. If the seller felt a need to cash out the mortgage more quickly, the 120-month payment (10 years) would be a bit long. On the other hand, if the seller had a seven-year-old child (or grandchild), the mortgage would provide a nice annuity to set up an education fund for the child. If the money was reinvested each time Ryan made a payment, over the 120 months at even a modest interest rate, there could be in excess of over 150,000 in the bank. If the seller balked at the terms, Ryan might have to sweeten the deal. So far, he is still 10,000 under the original price, which he thought was a good deal. In addition, there is room to maneuver with the terms of the second mortgage on the house. If Ryan had done some homework on the seller, he might have had his own stockbroker show how these payments into a mutual fund or...

## K 403b and 457 Accounts

SEPs, or simplified employee pension plans, are retirement plans that use IRAs or IRA Annuities as the receptacle for contributions. SEPs are often attractive to small business owners because of the reduced administrative tasks and expenses. Documentation, reporting, and disclosure requirements are simpler for SEPs than for qualified plans. However, in exchange for simplicity is the loss of flexibility. For example, under an SEP, all employees must be covered as long as they meet specified requirements, and the benefits must be fully vested at all times. SEPs allow employers to make contributions to an employee's retirement without utilizing a more complicated retirement plan, like a 401(k). You can use SEPs if you are incorporated or if you have self-employment income, so check with your CPA to see if you qualify to establish a SEP.

## The Guarantee Liability As A Derivative Security

In fact, all of the financial guarantees that were described in Chapter 1 can be viewed as derivative securities, based on some underlying asset. In the segregated fund or variable-annuity (VA) contract, the underlying security is the separate fund value. Similarly to derivative securities in the banking world, financial guarantees in equity-linked insurance can be analyzed using the framework developed by Black, Scholes, and Merton.

## The great credit monster

Check your 401(k) plan, your bond funds, and your insurance company's annuity. Why Remember those mortgages I spoke about earlier in this chapter Banks and mortgage companies issued trillions of dollars worth of those mortgages in recent years. But after the mortgages were issued, they were sold to other financial institutions. Huge amounts were sold to the most obvious buyers, the Federal National Mortgage Association (FNM) and the Federal Mortgage Assurance Corporation (FRE). These giant government-sponsored entities are usually referred to as Fannie Mae and Freddie Mac. They hold many mortgages but they also package and resell these mortgages to third parties, such as pension plans, corporations, and insurance companies. Remember that many of these mortgages are sub-prime (that is to say, risky). Hmmm. There goes that alarmist robot with the flailing arms again.

## Laddered government bonds a useful safetyfirst portfolio

The danger of having to reinvest at lower interest rates than prevailed when the maturing bond was purchased could have been avoided if a life annuity had been purchased instead of a bond ladder (though complicated tax issues arise if the annuity is purchased with taxable savings). However, the laddered approach is more appealing to many investors than a life annuity as it gives greater control over their wealth and avoids the need to lock in a single long-term rate of interest on the day they choose to purchase the life annuity. Although a ladder does involve reinvestment risk, it also offers reinvestment opportunity, namely the chance to reinvest at more favourable interest rates at a later date. This can even provide an important element of inflation protection to retirement income. If individuals did decide to buy a fixed-income life annuity rather than invest in a bond ladder, they would be wholly exposed to any unexpected increase in inflation for the rest of their lives....

## Controlling Longevity Risk in a Retirement Portfolio

In this chapter, we investigate the risk factors investors face when making decisions on saving and investing their retirement portfolios. We illustrate the common mistakes investors make in their asset-allocation and spending decisions in retirement. Using Monte Carlo simulation and optimization techniques, we illustrate the benefits of including lifetime payout annuities in retirement portfolios. Finally, we explore the idea of optimal allocation to payout annuities in an investor's retirement portfolio. We also offer a comprehensive asset- and product-allocation strategy that addresses the unique requirements of today's and tomorrow's retirees.

## Pricing By Deduction From The Separate Account

Where ais an n-month annuity factor, using standard actuarial notation, evaluated at rate of interest i' (1 - m)_1 - 1. The superscript t indicates that the annuity takes both death and withdrawals into consideration. So the appropriate margin offset rate for the contract is

## Internal Rate of Return Method

The meaningfulness of internal rates of return (and profitability assessments based on them) compared with that of the NPV or annuity methods depends on the cash flow profiles and, thus, on the type of investment. The following discussion concentrates on isolated investment projects. Such projects are characterised by the fact that the cash flow surpluses of the whole planning period only cover interest charges (at the internal rate of return) and repayment of the capital employed. That is, no reinvestment is made using the project's cash flow surpluses during the project's economic life. The investment is said to be 'isolated', and the internal rate of return is then independent of the interest rates that possible reinvestments might earn. As with the annuity method, the IRR method shows some advantages over the NPV method when it comes to interpreting the results. A project's IRR can be seen as representing the interest earned on the capital employed - an intuitive approach that...

## Variable Life Insurance

Just as with variable annuities, there are various subaccounts within a variable life policy. The policyholder can choose how the premium is allocated between the different subaccounts so that he or she can try to receive the best possible return on the money, all the while receiving beneficial tax treatment. These subaccounts usually represent each type of asset class thus, an insured person could opt to split his or her premium between a growth fund, fixed fund, and bond fund, for example. The growth of the cash value of a variable life policy is also tax-deferred. And, as with other types of life insurance, the beneficiary of a variable policy receives the death benefit tax-free.

## Pros And Cons Of Variable Life Insurance

The types of subaccounts vary with the company that is offering the policy, however you can generally choose from a wide range of asset classes. In fact, the subaccounts are set up like mutual funds. You could choose to have a portion of your premium invested in a junk bond fund, or perhaps a high-growth fund. The possibilities are only limited by the insurance company. You will also be able to switch between funds at no cost, just as you would be able to with an annuity. Plus, since the investment account grows on a tax-deferred basis, you won't be generating any capital gains tax when moving your money between accounts.

## Wanting tots and lotsa money Pat and Chris

Pat doesn't need life insurance because no one depends on Pat's income. Besides, it's a lousy investment (for the compelling reasons why you're better off not using life insurance for investing, see Chapter 1). Pat should dump the life insurance and either take the proceeds or roll them over into a variable annuity (which I explain later in this chapter).

## Wishing for higher interest rates Netl the near retiree

35,000 in an insurance annuity that's invested in a guaranteed investment contract and yielded 6.75 percent last year through her employer's non-profit retirement savings 403(b) plan. Nell currently earns 30,000 per year and has received pay increases over the years that keep pace with inflation. She has 250 per month deducted from her paycheck for the annuity plan. Her employer allows investments in the retirement plan through almost any insurance company or mutual fund company she chooses. She's also saving about 800 per month in her bank account. She hates to waste money on anything, and she doesn't mind some paperwork. Nell also could and should invest more through her employer's retirement savings plan because she is saving so much outside that plan and already has a large emergency reserve. In fact, she should invest the maximum, 20 percent of her salary. She also can do better to invest in no-load funds for her 403(b) plan instead of through an insurance annuity, which carries...

## The Cash Matching Problem

A simple optimal portfolio problem is the cash matching problem. To describe this problem, suppose that we face a known sequence of future monetary obligations (If we manage a pension fund, these obligations might represent required annuity payments ) We wish to invest now so that these obligations can be met as they occur and accordingly, we plan to purchase bonds of various maturities and use the coupon payments and redemption values to meet the obligations The simplest approach is to design a portfolio that will, without future alteration, provide the necessary cash as required

## Criteria for Selection Ask the Right Questions

Price and downside protection are important criteria in our selection process, as are probable catalysts and upside potential. We also prefer businesses with annuity revenue streams, low or very liquid inventory, and only as many coworkers as are needed to get the job done (sometimes reflected in revenue coworker statistics). Naturally, we also watch the business cycle to consider how macroeconomic trends might impact different kinds of businesses. Overall, we break our search into three general categories (see Figure 20.1).

## Hypothetical Household

For starters, we assume you intend to obtain a (level) annuity for your 25-year retirement period we postpone discussion of planning for the uncertain time of death. (You may well live to over 100 years what then ) Suppose your gross income this year was 50,000, and you expect annual income to increase at a rate of 7 per year. In this section, we assume that you ignore the impact of inflation and taxes. You intend to steadily save 15 of income and invest in safe government bonds that will yield 6 over the entire period. Proceeds from your investments will be automatically reinvested at the same 6 until retirement. Upon retirement, your funds in the retirement account will be used to purchase a 25-year annuity (using the same 6 interest rate) to finance a steady consumption annuity. Let's examine the consequences of this framework.

## Accounting For Inflation

Inflation puts a damper on your plans in two ways First, it erodes the purchasing power of the cumulative dollars you have so far saved. Second, the real dollars you earn on your portfolio each year depend on the real interest rate, which, as Chapter 5 showed, is approximately equal to the nominal rate minus inflation. Since an appropriate savings plan must generate a decent real annuity, we must recast the entire plan in real dollars. We will assume your income still is forecast to grow at a 7 rate, but now you recognize that part of income growth is due to inflation, which is running at 3 per year.

## An Alternative Savings Plan

Spreadsheet 18.3 shows that with an initial savings rate of 10 , compared with the unchanging 15 rate in the previous spreadsheet, you can achieve a retirement annuity of 59,918, larger than the 49,668 annuity in the previous plan. Notice that real consumption in the early years is greater than with the previous plan. What you have done is to postpone saving until your income is much higher. At first blush, this plan is preferable It allows for a more comfortable consumption of 90 of income at the outset, a consistent increase in standard of living during your earning years, all without significantly affecting the retirement annuity. But this program has one serious downside By postponing the

## Roth IRA with the Progressive Tax Code

Table 18.2 demonstrates the difference between the two types of shelters. The first line shows the advantage of the traditional IRA in sheltering contributions. Taxes paid during the working years are lower, yet taxes during the retirement years are significant and, later in life, you pay less tax with Roth IRAs (line 2). For the middle-class income we examine here, this is not sufficient to make Roth IRA more attractive, as the after-tax annuities demonstrate. The reason is that early tax payments weigh more heavily than later payments. However, one can find situations in which a Roth IRA will be more advantageous. This is why it is important for investors to check their unique circumstances. Those who are not able to do so themselves can log on to one of the many websites that provide tools to do so (e.g., http www.quicken.com).

## The Average Indexed Monthly Income

The series of a retiree's lifetime indexed contributions (there may be zeros in the series for periods when the retiree was unemployed) is used to determine the base for the retirement annuity. The 35 highest indexed contributions are identified, summed, and then divided by 35 X 12 420 to achieve your Average Indexed Monthly Income (AIME). If you worked less than 35 years, all your indexed earnings will be summed, but your AIME might be low since you still divide the sum by 420. If you worked more than 35 years, your reward is that only the 35 highest indexed wages will be used to compute the average.

## The Primary Insurance Amount

Table 18.5 presents the value of SS to U.S. employees who retired in 2002. The first part of the table shows how SS calculates the real annuity to be paid to retirees.9 The results differ for the four representative individuals. One measure of this differential is the income replacement rate (i.e., retirement income as a percent of working income) provided to the four income brackets in Table 18.5. Low-income retirees have a replacement rate of 60.45 , more than 1.5 times that of the high-wage employees (37.91 ). The net after-tax benefits may be reduced if the individual has other sources of income, because a portion of the retirement annuity is subject to income tax. Currently, retired households with combined taxable income over 32,000 pay taxes on a portion of the SS benefits. At income of 44,000, 50 of the SS annuity is subject to tax and the proportion reaches 85 9The annuity of special-circumstance low-income retirees is supplemented. When evaluating the attractiveness of SS as...

## Childrens Education And j Large Purchases

The question is whether planned, large outflows during the working years require a major innovation to our planning tools. The answer is no. All you need to do is add a column to your spreadsheet for extra-consumption expenditures that come out of savings. As long as cumulative savings do not turn negative as the outflows take place, the only effect to consider is the reduction in the retirement annuity that results from these expenditures. To respond to a lower-than-desired retirement annuity you have four options (1) increase the savings rate, (2) live with a smaller retirement annuity, (3) do away with or reduce the magnitude of the expenditure item, or (4) increase expected ROR by taking on more risk. Recall though, that in Section 18.2, we suggested option 4 isn't viable for many investors. The situation is a little more complicated when the extra-consumption expenditures create negative savings in the retirement plan. In principle, one can simply borrow to finance these...

## J The Rentversusbuy Decision

With all this in mind, it is evident that investment in a home enters the savings plan in two ways. First, during the working years the cash down payment should be treated just like any other large extra-consumption expenditure as discussed earlier. Second, home ownership affects your retirement plan because if you own your home free and clear by the time you retire, you will need a smaller annuity to get by moreover, the value of the house is part of retirement wealth.

## Intergenerational Transfers

In the context of a retirement plan we think of risk in terms of safety first, where mean-variance analysis is inadequate. We have already touched on this issue earlier, in the context of (1) raising the ROR with risky investments, (2) avoiding savings plans that rely too heavily on savings in later years, and (3) acquiring life insurance and including life annuities in the savings portfolio. Having discussed marriage co-insurance and bequest, we cannot fail to mention that despite the virtues of saving for the longest term, many individuals overshoot the mark. When a person saves for old age and passes on before taking full advantage of the nest egg, the estate is called an involuntary, intergenerational transfer. Data shows that such transfers are widespread. Kotlikoff and Summers (1981)16 estimate that about 75 of wealth left behind is actually involuntary transfer. This suggests that people make too little use of the market for life annuities. Hopefully you will not be one of...

## Insurance Company Accounting and Economics

There are three classes of insurance companies Life insurance companies offer long-term contracts that pay off in retirement annuities, or as lump sums upon the insured's death, property and casualty companies insure against hazards like worker injuries, automobile accidents, and flood and fire damage, and reinsurance companies take risks from other insurance firms that may be too large for the original underwriters to bear. All three types are heavily regulated and have three accounting systems statutory accounting for regulatory authorities, generally accepted accounting principles (GAAP) for reports to the public, and a set of accounts for tax authorities. Insurance companies also have two types of ownership. They are either publicly held in the traditional corporate form or held by their policyholders as mutual companies.

## Selfcontrol And Dividends

Why didn't these people simply create homemade dividends There are two psychological traits that explain this behavior mental accounting and self-control. First, making homemade dividends probably didn't even occur to these investors. Mental accounting (Chapter 8) causes investors to separate investments into different mental accounts. When investing for income, investors buy highdividend stocks, bonds, and annuities (Chapter 9). A different mental account and investment strategy is used for capital gains. It is difficult to think of a stock in the income mental account as having the potential to capture a capital gain.

## Valuing a Financial Company

Counts, annuity products, and pension products, and by selling those products to consumers. The FC uses the revenue raised from the sale of the secondary securities to purchase higher-yielding assets called primary securities, such as mortgages, loans, bonds, and stocks. The interest, dividends, principal, and gains from the primary securities, along with the other assets of the FC, pay the cash flows associated with the secondary securities the monthly pension checks, or the claims under a casualty policy, or the life insurance payment whatever products the FC has created.

## Price3713 Value4713 to 8803 Strong Buy General Description of Citigroupa Global Finance Holding Company

Incorporated in 1988, Citigroup (C www.titigroup.com ) is a diversified global finance holding company that services almost 200 million customer accounts and employs 268,000 employees in over 100 countries. Citigroup is the world's largest financial institution. It conducts its activities through subsidiaries that are leaders in their respective fields Citibank in commercial banking, Salomon Smith Barney in investment banking and brokerage activities, Travelers Property Casualty Corp. in property and casualty insurance, and the Travelers Insurance Company in life insurance and annuity products. Citigroup divides its operations and businesses into several groups Global Consumer, Global Corporate, Global Investment Management and Private Banking, and Investment Activities. Global Investment Management and Private Banking offer a broad range of asset management, insurance, and annuity products. Traveler's Life and Annuity, Citigroup Asset Management, and Citigroup Private Bank provide...

## Liabilityfunding Strategies

Liability-funding strategies are strategies whose objective is to match a given set of liabilities due at future times. These strategies provide the cash flows needed at given dates at a minimum cost and with zero or minimal interest rate risk. However, depending on the universe of bonds that are permitted to be included in the portfolio, there may be credit risk and or call risk. Liability-funding strategies are used by (1) sponsors of defined benefit pension plans (i.e., there is a contractual liability to make payments to beneficiaries) (2) insurance companies for single premium deferred annuities (i.e., a policy in which the issuer agrees for a single premium to make payments to policyholders over time), guaranteed investment contracts (i.e., a policy in which the issuer agrees for a single premium to

## General Description of Merrill Lyncha Great Securities Firm

The Private Client Group provides services and products related to the management of wealth, including broker dealer activities, banking, retirement planning, insurance and trust services, and mortgage lending. Brokerage activities are provided by two subsidiaries Merrill Lynch, Pierce, Fenner and Smith and Merrill Lynch International. Insurance activities consist of underwriting and marketing life insurance and annuity products written by Merrill Lynch Life Insurance Company and ML Life Insurance Company of NY.

## Long Term Yields and Stock Returns

The annuity cost graph is close to a mirror image of the long-term bond yields shown in Figure 12.2, so most of the comments made in the previous section also apply here. In this figure, we also show the short (three-month) interest rates, demonstrating the low volatility of the long rates compared with the short rates.

## Individual Retirement Arrangements

Most people are familiar with individual retirement arrangements, or IRAs. However, they may not be as familiar as they should be. An IRA is a powerful tool that will help you save money for your retirement, as well as shelter some of your money from taxes. Similarly, many people assume that an IRA is a specialized type of investment, perhaps a specific mutual fund or stock in which all IRA owners are invested. Not so. An IRA is strictly a type of account it's a category of accounts, not a specific investment. In fact, an IRA can hold stocks, bonds, real estate, annuities, or any type of investment you can think of. The types of IRAs, including the traditional and the Roth, are designed to promote retirement saving. With the introduction of the Roth IRA in 1998, retirement saving got a real boost because the Roth offers specialized tax features that no other type of retirement account does. Until recently, the annual contribution limit was 2000. This really didn't allow the IRA...

## Whats Different about Pension Funds

A defined-benefit plan is a traditional pension plan, where the benefit is defined as an annuity X a month for the rest of our life or a cash balance pension plan, where the benefit is defined as a lump sum. In either case, the plan sponsor bears the entire risk or opportunity of investment results. The employee is entirely unaffected.

## Charitable Remainder Trust

A CRT is a vehicle commonly used to diversify a low-cost-basis stock holding while making a partial gift to charity. Mr. Smith has just contributed 50 million worth of Smith Industries stock to a CRT he created. This stock had a cost basis of about zero, so we will treat it as zero in our analysis. If Mr. Smith had sold it he would have had to make an immediate capital gains tax payment of 20 percent of 30 million. Instead, Mr. Smith created the CRT, contributed the stock, and arranged for the CRT to pay him 10 annual payments of 2,800,000. At the end of the 10 years the balance of the CRT will go to a charity that Mr. Smith has designated. Mr. Smith has designated his foundation as the future recipient. The IRS requires that Mr. Smith determine the present value of this annuity and deduct it from 50 million in order to determine the amount of charitable donation Mr. Smith has made. The IRS identifies the appropriate discount rate based on the Treasury yield curve. We will assume a...

## Civil Service Pensions

The scheme does not permit any pre-retirement withdrawals. There are no government guarantees. The accumulated balances can be withdrawn at age 60. Only a portion however, cab be withdrawn in lump-sum. The rest will be either in the form of an annuity (requiring close coordination with IRDA), or a phased withdrawal option will be devised.

## Introducing Uncertainty into Valuation

Note that the default risk on the bond is reflected in the interest rate used Note that the cash flows over the next 12 years represent a growing annuity, and the present value could have been computed with a simple present value equation, as well. Note that the cash flows over the next 12 years represent a growing annuity, and the present value could have been computed with a simple present value equation, as well.

## Fixed Income Securities

Environment (due to faster than expected prepayments) and also less desirable in a higher rate environment (again due to prepayments). Think of an IO as an annuity of variable maturity, which contracts in a falling rate environment and also receives less than expected interest payments. In a rising rate environment, the life of the IO extends, exactly at the worst possible time, when an investor would prefer to have as much income as possible to reinvest at higher rates. 10s are often used as hedges to fixed-income securities due to their unique return characteristics.

## Moving Beyond Uncle

These insurance-like investments enable you to defer current taxes and capture a stream of income after you retire. Fixed annuities offer a set rate of return variable ones provide a fluctuating return. But what the defensive investor really needs to defend against here are the hard-selling insurance agents, stockbrokers, and financial planners who peddle annuities at rapaciously high costs. In most cases, the high expenses of owning an annuity-including surrender charges that gnaw away at your early withdrawals-will overwhelm its advantages. The few good annuities are bought, not sold if an annuity produces fat commissions for the seller, chances are it will produce meager results for the buyer. Consider only those you can buy directly from providers with rockbottom costs like Ameritas, TIAA-CREF, and Vanguard.11 11 In general, variable annuities are not attractive for investors under the age of 50 who expect to be in a high tax bracket during retirement or who have not...

## ABOUT the Contributors

Baldwin, CLU, ChFC, CFP, is president and owner of Baldwin Financial Systems, Inc., in Arlington Heights, Illinois, a registered investment-advisory firm serving both individual and corporate clients. He is a consultant and educator for major financial-services firms and brokerdealer organizations on life insurance, particularly variable universal life insurance and annuities, and he has designed and taught insurance courses for the American Institute of CPAs, the Illinois CPA Society, and the American Bankers Association. Baldwin has served on the board of governors for the Certified Financial Planner Board of Standards, on the board of regents for the College for Financial Planning in Denver, and on the board of directors of the Society of Financial Service Professionals. He is a member of the CCH Financial & Estate Planning advisory board and the insurance columnist for the CCH Journal of Retirement Planning. Baldwin is a nationally known speaker and writer in the areas of...

## Life Insurance Wrappers

An insurance wrapper is an insurance contract wrapped around capital to protect against loss or damage by a contingent event. Insurance contracts are risk-management tools. Financial advisers recommend that clients exposed to the risk of fire, theft, accident, and liability purchase adequate insurance to protect against those risks. The products we're discussing here use either a life insurance contract or an annuity contract as the wrapper. The question the informed client deserves to have answered is, Does this wrapper, the insurance contract, provide enough value in the form of protection against loss of capital to justify its cost Advisers sometimes fail to understand that once one of these contracts is wrapped around a block of capital, the legal nature of that capital changes in many important ways. Advisers need to understand the costs and features of insurance wrappers and to be able to explain them to clients so that they can make informed decisions about whether to use them.

## Excel Application

The PV function, for example, can be used for calculating several present value calculations, including simple annuities. Example 2 To calculate the present value of an annuity of 10 per month (paid in arrear) for 10 years at a rate of interest of 12 p.a. (convertible monthly), you would enter (in any cell in the spreadsheet) This returns 697.01 as present value for the annuity.

## Risk And Damage

Life insurance company guarantees annuity pay-outs in a rising market. Fund guarantees pension. Stockmarket performance varies. Stock market crashes. Profits dry up. Life insurance and pension fund capital falls so alarming regulators. Guaranteed annuity or pension threatened. Life company reneges on guaranteed annuity pay-out. Pensions reduced or entrants to scheme excluded. Clients threatened with bankruptcy of company. Policy-holders take losses on annuities.

## Annual Worth

The annuity framework provides an alternative method for expressing a net present value analysis. This annual worth method has the advantage that it expresses its results in terms of a constant level of cash flow and thus is easily understood. An annual worth analysis uses the same ideal bank to hypothetically transform the sequence to one of the form (0, A, A, A, , A). The value A is the annual worth (over n years) of the project. It is the equivalent net amount that is generated by the project if all amounts are converted to a fixed -year annuity starting the first year, We simply need to determine how to amortize the initial cost uniformly over 10 years that is, we need to find the annual payments at 16 that are equivalent to the original cost. Using the annuity formula, we find that this corresponds to 20,690 per year. Hence the annual worth of the project is 25,000 - 20,690 - 4,310, which is positive thus the investment is profitable Note that if the purchase of the machine were...

## Own That Company

Now that you have started saving your money, the question becomes where to invest it. Although you should have a financial plan from your financial advisor, it's important that you know some things about investing. In this chapter and the following three chapters, we discuss stocks, mutual funds, annuities, bonds, cash, and REITS.

## History

Weill, formerly the chairman and CEO of the Travelers Group, the parent company of Smith Barney and several other insurance, mutual fund and annuity companies, is largely responsible for taking this traditional old brokerage firm, which, for much of its history, had not shown much of a yen for expansion, and placing it in front of the rolling snowball of frenetic financial services mergers of the late 1990s.

## Finite Life Streams

FIGURE 3.1 Time indexing., Time is indexed from 0 lo n. A period is a span between time points, with the first period being the time from 0 to 1 A standard annuity has a constant cash flow at the end of each period This is the sum of a finite geometric series If you do not recall the formula for this sum, we can derive it easily by a simple trick. The value can be found by considering two perpetual annuities. Both pay an amount A each year, but one starts at time 1 and the other starts at time n -f 1. We subtract the second from the first The result is the same as the original stream of finite life This combination is illustrated in Figure 3 2 for the case of a stream of length 3, The value of the delayed annuity is found by discounting that annuity by the factor (1 + r) because it is delayed n periods Hence we may write Annuity formulas Consider an annuity that begins payment one period from the present, paying an amount A each period for a total of n periods The present value P, the...

## Summary

Many fixed-income securities make periodic payments to the owner of the security This is true, in particular, for mortgages, loans, annuities, and bonds In the case This single formula can be used to evaluate most annuities, mortgages, and bonds, and it can be used to amortize capital expenses over time

## Discounted Cash Flow

Determining projected future cash flows (known as pro forma cash flows) can be done several ways. An easy way is to take the current year's reported earnings (i.e., the company's after-tax net income) and multiply by some number such as the average earnings growth rate for the last five years. This gives projected net income for next year. Usually, earnings are projected for the first five to seven years, after which a terminal value is added. (The terminal value is equal to an annuity beginning in a future year, discounted back to present.) Since accounting income is often a poor proxy for cash flow, analysts will carefully calculate The Free Cash Flow by starting with EBIT (earnings before interest and taxes), taking out taxes on those earnings, and adding back interest, depreciation, amortization, and other cash-affecting items.